We have been discussing flawed analysis of the Quant Equity Crash of August 2007 in James Weatherall's The Physics of Wall Street. This leads to a more general topic: Why traders have a worldview that appears irrational to many outsiders.

Let's begin with a trader noticing a mispricing. The simplest kind of mispricing is something like dual class stocks where two securities with identical economic rights sell at different prices, and when the one with more legal rights is the cheaper one. This leads the trader to buy the cheaper stock and short the more expensive one. She can make money if the two prices move closer together, in which case she can close out the position at a profit. If the prices stay the same or move farther apart, she can make money through carry, holding a theoretically riskless position with negative capital.

In a naïve view, traders taking advantage of this anomaly will cause the prices of the two securities to converge smoothly to a point where the income from carry is just enough to attract the amount of capital to keep the securities price differential at the new equilibrium point. If more money comes in to the strategy, perhaps because investors are putting more money in hedge funds that do this sort of thing, the prices will move closer; if money exits the strategy, perhaps because financing costs go up or better opportunities open up elsewhere, the prices will move farther apart. On a macro level, this leads to a market in which every security price is in equilibrium. This gentle picture is in the back of the minds of many outsiders.

Now let's think about what actually happens. The first point is that the original security price differential existed for a reason. When you push back on this reason by trying to take advantage of the spread, it could cause a variety of reactions, just as you get a different result pushing on a mattress, a brick wall, a string, a pendulum or a sheet of glass. Moreover, that price differential can be connected to other things in the financial market that will react indirectly to your trading, and whose reaction can be transmitted indirectly to you. While the immediate effect of your trade order will be to move the prices of the two securities closer together, in my experience the medium-term effect of your effort to exploit this anomaly is about equally likely to make it bigger or smaller. The one thing you can count on is that it makes markets less stable. People who say financial trading causes prices to move closer to their fundamental economic values are spouting faith-based dogma that is contradicted by experience.

Next consider the reaction of other investors. If you cross-examine people who hold the naïve view of the effect of trading on prices, you will discover it is based on conflicting beliefs. Belief one is that your success in this strategy will attract other investors, so the more the two prices move together, the more success there is, and the more money that comes into the strategy, so the more the two prices move together. Belief two is that as the two prices get closer together, the trade becomes less attractive, so the more the two prices move together, the more money flows out of the strategy. In the sloppy analysis of people who haven't thought much about this, belief one operates first, but is replaced by belief two after the price differential has narrowed to an appropriate level.

In fact the reaction of other traders will be varied. For one thing, they will be looking at other spreads. You're trading Class A of a stock versus Class B of the same stock. Another trader might be trading either class of the stock against another stock in the industry. A third trader might be trading that industry against another industry, or stocks of that country against stocks of another country, or anything at all. Or a trader may have a benchmark and evaluate all performance relative to it. Another difference is traders working in different currencies will see different price trends (for example, if the yen has weakened, a security whose price went down to a US dollar trader may be a security whose price has risen to a Japanese trader). Still other traders are looking not at the price levels but the statistical properties of the return distributions so what will matter is not the direction of your trades, but how they affect the volatility of the stocks and their correlations with other stocks, or perhaps more arcane properties tracked by technical analysts. Traders are looking at things in different time windows, with different financing costs and constraints and different information sources. So lots of traders will change lots of trades as a result of you pursuing this strategy, and the changes will occur with different time lags, so the net result will be complex to predict.

Of course traders and risk managers try to think through all the effects of their activities, in terms of fundamental economics, behavioral effects and institutional reality-with a strong dash of empirical wisdom-but there are always surprises. Therefore we observe and try to react quickly to unexpected effects, and we work hard to find ways to reduce the potential damage from them. Every trade is both a bet and an experiment. Strategies evolve constantly (not necessarily rapidly, some strategies are essentially unchanged over 40 years or more, others lose their value in the course of days).

The resulting system is neither random nor predictable. While scientific investigation has made important progress in some areas, successful practice requires an enormous amount of knowledge gained from experience, without theoretical basis, plus unrefined theory still rough enough to look like valueless nonsense to outsiders. It is this aspect Weatherall fails to appreciate when he exhorts everyone to "think like a physicist." I will postpone discussing what Weatherall means by that, he is right in some ways, less right in others. But the most important finding of finance, based on long and bitter experience plus some subtle theory that has not yet made its way into textbooks, is that there is a deep connection between trying to make things more predictable and inviting extreme disruptive events.

This is not the usual situation in physics, and accepting it comes naturally only to experienced risk takers. Many physicists who have not organized their lives around risk have difficulty with it. Their training can encourage them to assume the people saying it are superstitious defeatist incompetents and that a little better modeling by a little smarter people with a little more training in physics will remove the curse. Not all physicists think that way, of course, and by no means everyone who thinks that way is a physicist. Where physicists sometimes distinguish themselves is with the arrogance behind their faith, with their willingness to ignore repeated strong evidence and especially to ignore the opinions of experienced and successful practitioners. This is the quality I found in Weatherall's book, that prompted me to begin this series.

This leads us naturally to discussion of Nassim Taleb and Black Swans, something else Weatherall misunderstands through arrogance. I'll get to that next week.

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